Tuesday, February 17, 2009

Texas Strictly Construes Forfeiture-for-Competition Clause (Valley Diagnostic Clinic v. Dougherty)

Not all restraints of trade are treated equally. In virtually all jurisdictions, covenants ancillary to an employment contract are subject to strict scrutiny for reasonableness and undue hardship. On the other hand, courts readily enforce sale-of-business covenants. And non-compete clauses which are ancillary to other relationships, such as distributorship agreements, can fall into either category depending on the facts and the bargaining position of the parties involved.

Another category of covenants has received comparatively little judicial scrutiny over the years. Forfeiture-for-competition clauses do not, technically, restrain an employee from working in a particularly industry, but they exact a price for doing so. A typical forfeiture covenant arises when an employer provides an incentive to an employee to stay with the company for a period of time. The incentive typically is some form of deferred compensation or stock options. Agreements are written to grant an employer the ability to not only forfeit unpaid compensation or vested options, but also to clawback income paid out pursuant to the incentive plan for, say, the year preceding termination.

Courts have taken two general approaches to resolving the validity or enforceability of these restraints. The majority view does not view a forfeiture provision as a restrictive covenant, and in jurisdictions adopting this view, the forfeiture clause will not be subject to a reasonableness inquiry. Courts in Missouri, Indiana and New York follow this line of reasoning.

A second, and minority, line of cases will examine the forfeiture clause as a restrictive covenant, reasoning that the intent of the arrangement is to restrain competition - if not in language, then certainly in impact. Nebraska, Wisconsin and Connecticut take a more dim view of forfeiture provisions. In Illinois, the cases cut both ways.

Add Texas to the minority. In Valley Diagnostic Clinic v. Dougherty, the Court of Appeals of Texas held that a forfeiture-for-competition clause within a medical practice's bylaws will be construed under Texas' Covenants Not to Compete Act because the intent was clearly to restrain competition with the medical practice by a departing shareholder. Under the facts of the case, the forfeiture provision was invalid because it was not designed to enforce any return promise on the part of the shareholder. The precise holding was based on an antiquated and confusing line of Texas cases interpreting its ancillarity requirement for non-competes.

The decision holding that a forfeiture clause is subject to strict non-compete scrutiny arguably contravenes a 1975 Texas case, Dollgener v. Robinson Fleet Services. That case clearly held that a forfeiture provision within a non-contributory profit-sharing plan was not subject to a restrictive covenants analysis because it was not a negative employment covenant. Though the court did not discuss Dollgener, it is possible the Texas legislature's enactment of the Covenants Not to Compete Act abrogated the older line of cases. Still, had it done so, the court should have discussed the ruling and clarified the law in this regard.


Court: Court of Appeals of Texas, Thirteenth District
Opinion Date: 2/12/09
Cite: Valley Diagnostic Clinic, P.A. v. Dougherty, 287 S.W.3d 151 (Tex. App. 2009)
Favors: Employee
Law: Texas

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